Is $100 oil here to stay?

“The world of energy may have changed forever,” according to Professor James Hamilton of the University of California. “Hundred dollar oil is here to stay.”

Hamilton, who is one of the most respected economists writing about oil, made his bold prediction in a paper on The Changing Face of World Oil Markets, published on July 20.

“Old hands in the oil patch may view recent developments as a continuation of the same old story, wondering if the high prices of the last decade will prove another transient cycle with which technological advances will eventually catch up,” he wrote. “But there have been dramatic changes over the last decade that could mark a major turning point.”

The shale revolution will turn out to be only a pause in the upward trend in prices, Hamilton argues, as growing demand from emerging economies and stagnant supplies from conventional oil fields push prices higher in the long term.

“Rather than a force pushing oil prices back to historical lows, it seems more accurate to view the emerging tight oil plays as a factor that can mitigate for a while what would otherwise be the tendency for prices to continue to rise.”

IGNORING SHALE
The problem with Hamilton’s analysis is that it largely ignores the impact of the shale revolution on the economics of oil production and understates the tremendous variability in real oil prices in response to changes in technology.

The professor devotes just 400 words out of almost 4,000 to discussing the production of crude oil and gas from shale formations.

Most of that discussion focuses on the high cost of drilling and fracturing shale wells; the rapid decline in production; the alleged unprofitability of shale wells; and question of whether the conditions that produced the shale revolution in North American can be replicated in other parts of the world.

But this part of the paper is also the weakest, and it highlights the fundamental limitations with Hamilton’s entire argument about the increasing difficulty and costs of producing crude oil.

PEAKING OIL
Since 2008, the dramatic increase in oil and gas production from shale formations in North America, and the abundance of shale resources around the world, has discredited theories about peaking oil production.

The simple theory that supplies will run out has been reframed as a more sophisticated one about
rising prices.

Peak oil supporters now point to the increasing cost of oil production, diminishing energy return on investment and the diminishing energy return on energy invested to claim that it is becoming harder and more expensive to sustain, let alone increase, crude output.

Prices must continue to rise in real terms, they say, to reflect the increasing cost of producing crude and to restrain demand. Price increases will prove to be just as disruptive as physically running out of the stuff.

Hamilton’s paper lends influential support to this view. He notes that oil demand is now being driven by rising incomes in emerging markets, even as high prices restrain consumption in the advanced economies.

He also claims that much of the growth in oil production since 2005 has come in the form of he calls “lower quality” natural gas liquids, which have a much lower energy content and energy density than conventional crude.

Production of conventional crude oil has stagnated, despite surging prices and unprecedented spending on exploration and production activity.

“Depletion of older reservoirs and the high cost of developing new resources” explain why
conventional oil output has not responded to climbing prices, Hamilton concludes.

SHALE SKEPTIC
The paper is skeptical about whether shale oil can alter the supply outlook fundamentally because of its high production costs and the difficulty of replicating the boom outside the United States. But this is the least convincing part of Hamilton’s argument.

The paper confuses the struggling economics of dry gas wells with the much more attractive economics of wet gas and oil plays.

If oil wells were not extremely profitable, North Dakota and Texas would not be experiencing a drilling boom, with demand for both rigs and petroleum engineers at the highest level for three decades.

In focusing on decline rates, Hamilton ignores the ultimate amount of oil and gas recovered from
shale wells, which in many cases is higher than from conventional wells.

The second section of the paper suggests that much of the increase in oil output since 2005 has in fact been “low quality” natural gas liquids rather than true crude, but then the fifth section acknowledges production from shale has increased U.S. crude output by a net 2.3 million barrels per day.

In fact, statistics from the U.S. Energy Information Administration show the shale boom has produced a dramatic increase in both natural gas liquids and true crudes. It is simply not true to imply that the oil industry is finding only “low quality” hydrocarbons.

One of the biggest problems of the paper is that it confuses the period between 2005 and 2008, when output was struggling to meet demand, with the more recent period from 2009 through 2014, when output from shale has grown quite quickly and global oil demand growth has slowed.

PRICE FORECAST
Even if shale continues to boost overall U.S. oil production, “it is abundantly clear that it would not return real oil prices to their values of a decade ago”, Hamilton argues.

According to the BP Statistical Review of World Energy, the real price of crude oil, adjusting for inflation, has ranged from as much as $120 per barrel to as little as $10 since 1861.

The price is currently close to the top of its historical range, while in the 1990s and early 2000s it was near the bottom.

So oil prices could retreat from their current highs by $20, $30 or even $40 per barrel and still remain quite high in historical terms.

By comparing current exceptionally high prices with the very low ones that prevailed “a decade ago”, Hamilton risks using a misleading baseline.

North American shale is currently the marginal source of supply in the world oil market, and most producers claim they can break even at $70 or even $60 per barrel.

TECHNOLOGY
Prices have varied enormously over the 155-year history of the oil industry, mostly in response to large discoveries and changes in technology.

The collapse in oil prices during the late 1920s and 1930s was largely due to the discovery and development of massive new fields in East Texas.

Low prices from the 1940s through the 1960s owed much to the massive discoveries in the Middle East around the Persian Gulf and in North Africa.

Massive new fields in Siberia and Alaska, as well as the development of deep offshore drilling in the North Sea, eventually contributed to price declines in the late 1980s and through the 1990s.
But the history of oil prices is as much about the history of technology as field discoveries.

In a very basic sense, production costs have been rising since the industry was born. As in all extractive industries, the easiest oil was developed first, and more expensive oil has been developed later. Hamilton’s argument that costs are increasing could have been made at every stage in the oil industry’s history.

The first wells in Pennsylvania tapped oil buried less than 100 feet below the surface. By the mid years of the 20th century, wells were being bored thousands of feet below ground. Then in the 1970s the industry turned to offshore drilling, which was even more tricky and expensive. Now it is mastering the art of drilling horizontally rather than vertically.

But productivity has also increased as companies have learned to target the highest yielding formations and drill faster and more accurately. Hamilton’s paper is silent on all these matters, and that is ultimately what makes it unconvincing.

The paper is also silent about climate change, policies to restrict the consumption of fossil fuels, and the growing challenge to oil-based fuels from natural gas even in the transport market, all of which could depress real prices in the medium to long run.

So while Hamilton concludes that $100 oil is here to stay, in real terms, the outlook is far less certain. In fact, a betting man, looking at the price history, might conclude prices are currently abnormally high and due for a fall.

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